Magazine

Euro Zone: New Inflation Worries at the ECB

May 26, 2002

The European Central Bank turned decidedly hawkish at its May 2 meeting. The ECB must contain inflation while positioning the euro zone for an economic recovery later this year. Given the new stance, an interest-rate hike could come as early as July, before any anticipated action by the U.S. Federal Reserve.

The central bank kept rates unchanged at 3.25% but raised its inflation outlook. ECB President Wim Duisenberg said price pressures will recede, but maybe not enough to push inflation below the ECB's 2% target. Initial April data show prices rising 2.2% from a year ago, led by higher oil prices, but new data from France, Spain, and the Netherlands suggest an even higher final reading.

The rounding up of prices during the euro changeover had a bigger impact than anticipated. March core inflation--excluding energy, food, tobacco, and alcohol--was 2.5%, up from 1.6% last March. Service inflation, at 3.2%, is high and rising.

The ECB's new inflation worries come just as the economy is set to pick up--with policy already very stimulative. The bank expects real gross domestic product to grow 2% to 2.5% by the fourth quarter and at a faster pace in 2003. The ECB is especially concerned about current union negotiations in Germany and Italy. Wage growth already exceeds inflation, and Duisenberg said that a sharp rise in labor costs would have a long-term effect on prices.

Several factors could stay the ECB's hand: Domestic demand is weak, with March unemployment stuck at 8.5% for the fifth month in a row. The European Commission pared its second-quarter GDP growth estimate to 0.4% to 0.7%. That means pricing power remains slack, and businesses may respond to higher negotiated wage increases by cutting their payrolls. Plus, growth in the key M3 money supply is slowing.

Still, the euro zone's recovery is set to begin amid stubborn inflation and high unemployment. But since inflation is the ECB'S only concern, it may not wait long to begin raising rates. By James C. Cooper & Kathleen Madigan